How to Use Commercial Real Estate to Add $1M to Your Net Worth in 5 Years

This is the story of how to add $1M to your net worth in 5 years by purchasing a 21-unit apartment building at fair market value, raising the rents by just $100 per unit and controlling costs.

When I first got started with real estate investing, I chose to flip houses. I felt like I could wrap my head around that and have a reasonable shot at being successful. Not long after that decision, I met an experienced investor (we’ll call him “Sam”) who owned some multifamily properties. He didn’t judge my decision, but he did point out that commercial real estate has three ways of making money, while flipping houses (and wholesaling for that matter) only had one.

He said, “Son, why are you wasting time with houses?”

“Don’t you know that you can make money three ways with commercial real estate? And the money you can make with it is a whole lot more than with houses.” He went on to explain that commercial real estate can make you money from cash flow (which I knew, duh!), from the tenants paying down the loan (makes sense) and also from appreciation that you control (say what?). According to Sam, when you put all three together, you can create extraordinary wealth.

“Here, let me show you.” Then he sat me down with a simple scenario that I will now share with you.

The Scenario

Imagine that you purchase a 21-unit apartment building at fair market value (an 8% cap rate for this scenario). The current average income per unit (after vacancies, etc.) is $1,000 per month.

You found this deal through a residential real estate broker who is a friend of the owner. The owner is an older gentleman who has owned the building for years. His property manager kept up with repairs, but they have chosen not to raise rents in a long while to keep the tenants. While he’s done a good job keeping turnover low, his expenses are unusually high.

In reality, the rents in the market are actually $200 higher per unit, maybe even more if you fix the place up. You and your property manager within a year or two could decrease expenses by 10%.

You decide to purchase the building because actual financials indicate an 8% cap rate. Your goal after TWO years is to have increased the average income per unit by $100 per month and to have decreased expenses from 55% of income to 45%.

Sound outrageous so far? No. Doable. Absolutely.

Now take a look at the (financial) results of this plan when you combine all 3 profit centers (cash flow, loan amortization, and appreciation)—your total profit is one million dollars after you sell in five years:

NOTE: Before you flame me in the comments below, let me just say that I’m keeping this model as simplistic as possible to make a point. For example, I don’t accommodate things like closing costs, bad debt, upfront renovations or if you have investors (which you should). I have a much more sophisticated deal analyzer that incorporates these things, but this is not necessary for our discussion. 😉

Raising the rent by only $100 per unit and decreasing expenses by 10% of income increases the net income by $53,000 per year. Not a huge amount, it seems, but when you apply an 8% cap rate to that number, that translates into an increase in value of the building by about $660,000.

Staggering.

And this doesn’t even count the principal reduction of $121,000 (principal that is being repaid by your tenants!) or the cash flow of $407,000 you’ve enjoyed over the past five years.

You took a $350,000 down payment, optimized the performance of this building, and parlayed that into one million dollars in five years.

Conclusion

Very few other businesses allow you to leverage your time, money, and skills in the way the commercial real estate does, which is why it’s the BEST way to achieve your financial goals using real estate.

My meeting with Sam was eye-opening for me, and I’m glad he cared enough to share his experience with me. From that point on, I vowed to get out of flipping houses (as profitable as it was!) and get serious about apartment building investing. Now it’s my primary focus, and I enjoy helping others do the same.

Maybe this article will inspire you to do the same. What do you think: Is commercial real estate the best way to achieve financial freedom?

Let’s talk in the comments below!

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About Author

Michael Blank’s passion is being an entrepreneur and helping others become (better) entrepreneurs. His focus is buying apartment buildings by raising money from private individuals. He’s been investing in residential and multifamily real estate since 2005. He is the creator of the Syndicated Deal Analyzer and the eBook “The Secret to Raising Money to Buy Your First Apartment Building”.

76 Comments

Three things came to mind as I looked this over……..House_of _Cards. Sorry I just dont see it. It looks beyond risky. Today..with oil price low and oil stocks low. I will put that same 354k down payment on a good oil company and in 5 years? My guess is I beat your projected return easily.And in the meantime ..and to do this trans action will take 10 seconds to buy and sell and to boot all the while I can collect a 5-10% dividend on my money. Risk v Reward……I just see too much risk. Good luck and thanks for the post

Hey, Its just not for me. That said the risk takers may be all over it. I see too many chances to go wrong. You havent forgot.these deals do not always go as planned? I see the design of the deal and understand it. So did so many in the downturn. I remember all to well what happened then.

Again…more power to ya if you like the deal. Its not my cash. One has to invest in what they know. I go to real estate for safety….not risk.

Or the oil company could be tanked by $55/barrel oil and your $20/share stock could go to $0.12. The best part is you have absolutely no control of the company management or externalities. You’re scared of the perceived risk of investing in real estate because you don’t know the risks. When buying real estate you have a building inspection done. Things could be missed, but a decent inspector will give you a really good picture of the deferred maintenance and risks. Then you have insurance to cover catastrophic damages. You may run into trouble with bad tenants or management problems, but the real estate will never be worth nothing. You may not be able to execute your plan, but the real estate won’t just go poof in the night like a stock can.

And to your point, I see your strategy as the risky one. Investing 355K in a company that you do not control and have no idea about the internal workings of. Except, that is, what they report publicly. Betting on a sector via an ETF I could see, betting on a single company, no thank you. Even a sector is too tied to Geopolitical BS, scandals and the public’s current greed vs. fear cycle. Lower maintenance yes, more passive yes, less risky no.

We have a long history of oil prices. Its not debatable like opinion. If you think oil goes on forever yes I can see fault in my plan. Maybe you do…maybe oil never runs out. Hmmmm….interesting. And an ETF…….OH MY thats for the 401k crowd who pay a guy to do the work. …anyway enuff of this. Its another topic.

I’m with Ryan and Jeff on this one, Jay. Investing in an asset where you have control over, rather than putting money towards a stock who does not have quite the efficiencies that a direct asset has is a risky game.

Sorry, I will take the real estate investment any day. You pay ordinary income rates on dividends and capital gains taxes when you sell. I doubt the dividend cash flow will come anywhere near the multifamily. Also real estate offers too many tax benefits. Houston housing inventory at 3 months which means a 10% increase in housing value per year. Real estate is not manipulated by 3rd parties. How many companies now paying even 5% dividend will be able to maintain payout with revenue crashing from low oil prices. I see that as much more speculative. Each to his own,

@JAY C
How about some calculations – or better yet, a real life example to back up your statement? Without a doubt, there is risk in ANY investment, however as others have pointed out that risk can be mitigated by doing your homework; careful analysis, realistic numbers, thorough inspection, market and historical data, etc. It’s not as if owning an apartment building is such an unusual investment that there are no successes to emulate, or failures to learn from.

Could be a good investment. I bought more of a RE style oil investment when prices were really low, so far so good and its performed at least as well as anything else. Wouldn’t buy into an ETF or an oil company but if thats your flavor there are lots of oil field deals that work in much the same way (i.e. increase income and increase value). There is no magic here, people are willing to pay X for one dollar in earnings. If there are more earnings OR people value the earnings at a higher amount price goes up. Works this way in every market. Diff is with stocks there are way too many moving pieces so forecasting earnings is very tough. RE also has pitfalls though which none of the cheerleaders ever really talk about. You have a loan at a coverage ratio of say 1.5x so if your vacancies rise, your costs rise, you are not as good an operator as you think you are, your employees steal from you, etc. you can be in trouble. Its a highly leveraged business essentially. Its def not risk free or for a faint of heart in my opinion.

Great article. I wrote another one similar on my site explaining how multi-family is the best way to potentially make millions, and you well-illustrated the major points.

One thing you could also do is do a cash-out refinance, after only two years. This would allow you to pull out the difference in value as debt, and use that to purchase another similar property. This route allows you to keep the first property’s cash flow, and build additional cash flow and net worth with a second.

Because we pulled out the difference as debt, it’s automatically tax free.

If it were me, I would probably go the cash out refinance route, acquire a second similar property, and then sell both with the intention of purchasing (via a 1031 exchange) a much larger property. Of course, it’s all in the details.

Ironically, the larger the property, the easier it is to manage. This is because the larger the property the more affordable a professional management staff becomes. This allows the investor(s) to deal with management and not so much the tenants.

Michael, thank you for the amazing article. Such a simple strategy, yet so powerful. Add it with syndication, rinse and repeat, and the sky is the limit. Looking for more great examples from you! Hopefully, sooner rather than later, I can turn this strategy into reality for myself.

Great blog post, I really enjoyed it and I hope you keep them coming! As you noted there is a lot more that goes into it, but you did a great job of illustrating the big picture. The more I learn about commercial multi-family the more appealing this niche becomes.

Hey Dale, I don’t think your delivery is going to drum up any business for the service you are offering. Just my own 2 cents haha. I believe there is no one “right way” to do anything in real estate, and I usually run away from anyone that says something “can’t” be done.

Hi Daniel … 45% is a hypothetical because every situation is different. Hypothetical, yes, but realistic given the right situation and property manager. Examples of what you might do to reduce expenses:
— Lower payroll overhead. If the previous property manager employed a full-time maintenance person and leasing agent for managing a 50-unit, you’ve got a problem. A good property manager should be able to do without that pay roll
— Appeal real estate tax assessment: I’ve done that successfully and saved $1500 per year.
— Install water-savers throughout to really reduce water if you’re paying for it.
— Shop your insurance: I cut my insurance about 30% over the previous owner by doing just that.
Just some examples …
Thanks!

Hey Daniel — As I’ve inferred from Michael’s post, none of this strategy involves being previously recruited by M.I.T. I know, cuz they never darkened my door. 🙂

None of this is rocket science, though most, unlike Michael, either won’t, or can’t execute the various skill sets required. Michael has learned how value is added, and pursued that strategy. Though there are some things I’d add to the mix, his results, even if cut by 1/3, are impressive, and obtainable. What goes unsaid is the difficulty of locating a building for which the rents are indeed below market, AND can be bought based upon those low rents, not market rents. In real life that’s often not the case. Also, it matters HUGELY the relative quality of location.

But what Michael did here was a demonstration in principle of what’s conceptually doable, given the availability of opportunity. The difference between him and the other 90% is that Michael has the, um, intestinal fortitude to make it happen.

Great article Michael. Hopefully without sounding too negative, I would also point out that different assumptions could result in a very different outcome. I couldn’t help but notice that in your example more than 50% of the net profit comes from appreciation. This leaves a large part of the ultimate success of the deal to a very unpredictable factor.

Also, I think anyone investing using this strategy with the expectation of an exit cap rate in 5 years remaining at the same level is taking a lot of risk. It’s important to stress the investment at various exit cap rates in order to understand the impact on the overall deal and then decide whether it makes sense.

No appreciation and a slightly higher reversion cap rate turn your example from a home run to mediocre very quickly, especially considering all the time and effort invested in adding value through rent increases and expense reductions. I know your article was used as an example and I know you are well aware of these risks, but I think it’s important for others to be able to assess an investment from both a best case and worse case scenario before making a decision.

Of course, it’s also possible that you are able to increase rents to an even greater degree and appreciation is even stronger than your assumptions. In this case, the deal may turn out much better than portrayed! The point is, proforma assumptions can be easily manipulated and justified to show a desired outcome, which many people dangerously rely on as fact.

Nice job you guys! While its obvious the numbers and scenarios in this example can be changed which in turn will alter the results, markets can change and alter results, what is also and more important to success as an investor is also obvious here. If you are easy to say something cannot be done, or are afraid of failure, the rewards won’t be there and never will be. The 2 biggest obstacles to progress or success are fear of failure, and the words it can’t be done.
RR

Nice article. While some have indicated that it is too much work and too much risk, I see it as a risk that I have a great deal of control over. My commercial investment was a 17 unit and I was able to increase my cashflow by $80 per unit with a simple improvement. I separated the meters, so that the tenants pay for their own water and sewer. The rents were too low, so I installed the meters for $250 per unit and then waited for the tenants to move. The new tenant moved in at the same rent, but no more free water!

I could have increased rents or charged the existing tenants when their leases were up, but this way it was gradual and did not involve a lot of unnecessary vacancy. Also, you would be amazed at how much the water bill went down when they knew we were monitoring it apartment by apartment. We figured we would give an immediate increase to anyone who was abusing the system. (Also, we asked one tenant to move when he refused to let us in to fix the water leak that became evident by his 2X normal bills.)

With this simple change, our cashflow increased and thus the value of the property is higher when we sell it.
By the way, for those who advocate stock market investments over real estate, my cashflow on the rentals increased when the real estate market crashed. (Foreclosures = more tenants) That was not true for stocks during a crash. They cut dividends.

Michelle
When you separated the water meters, how did you do it? didn’t that require separating the plumbing? I am curious how you could do that for only $250 per unit, and is each tenant responsible to supply deposits and have a separate water bill as opposed to the building having only one water meter/bill? Also what happens if a tenant doesn’t pay his water bill. My houses are subject to a lien if the water falls in arrears. As a result the one SFR. I own sticks me with a water bill 2 out of 3 turn overs. If I’m lucky (there’s no major damage to the house) I can get reimbursed from the damage deposit. Thanks in advance for your help
RR

When we purchased it, the building had one meter located outside the building, then the water line had an entry point for each townhouse apartment in the laundry room. The city required that we purchase a meter for approx. $100 per unit and pay a plumber to install for about $150 per unit. These were installed at the point where the water entered each apartment.

In our small town, the city charges a large deposit (enough to cover the typical 3 month bill). If someone doesn’t pay for 2 months, then they turn off the water. The deposit usually covers any unpaid amounts. Before they instituted the large deposits, we had to check with the city regularly to be sure our tenants were paying. Another option that we use for properties in a different city is to put it into the lease that we pay the utility bill, but they must reimburse us. This makes it impossible for them to not pay the utility bill without you knowing, and you can evict if they don’t pay. It creates more work, but in that town they were not good at letting us know when people did not pay.

Thanks Michelle. I am doing the check with the water department method on the rental where the water is the tenants responsibility. Im not so fortunate about the others. I must split the plumbing to separate the meters. so I had to build the usage into the rent.
RR

We buy apartments. But we tend to make our money “upon the buy” rather than on the expectation of increased rents. If we are able to increasing rents, great, but we are not counting on it. For example, we negotiated a short sale on a 28 unit apt building with BofA on a $1,250,000 loan they had against it, and ended up buying it for cash at $341,000….. ie, make your money upon the buy. The good news is that yes, we can raise rents by $50 per month, thanks to a new employer in town and the cities future growth. Deals like this do make you rich, but the real work is finding them in the first place. Hence, why tdlcapital gets great partners.

Yeah, I think I agree with you Treg. We bought a four plex earlier this year (also BofA short sale) and have been rehabing and raising rents. But the rehab costs are higher than projected (what else is new?) and so while the NOI increase is there on paper it really isn’t much when accounting for financing the CAPEX. By comparison, I passed on another fourplex in 2010 during the depths of the recession that the owner was practically giving away at $225k which resold this summer at $425. Unless you are willing or able to go to the markets where the cap rates are higher its better to keep your powder dry during times like these and wait and buy when sellers are motivated. Warren Buffet said the same thing about stocks, “be bold when others are afraid, and afraid when others are bold” and I think its just as true for buying RE. There is a lot of boldness out there now that markets are starting to recover and this boy is going to sit on the side lines for awhile. Better to make no deal than a bad one.

Just to play devil’s advocate, one risk is doing this today is that with interest rates likely to rise in the coming years (how fast or how far is anyone’s guess), cap rates will likely follow. So your 8% cap deal today could very well be a 10% cap in 5 years.

Increase revenue by 10% and decrease operating expenses by 20%? Yeah, I can make a million dollars in 5 years with a lemonade stand doing that. Easier said than done since the market drives rent prices. I would also expect expenses to increase, not decrease, as the property ages. Just my 2 cents, but it’s these type of pie-in-the-sky articles that push a lot of suckers into doing deals they have no business taking on.

While I agree in MFH as a great way to build wealth, the gross rents are overstated. $250k/yr on a property that costs $1.4mm? I think it is more around $200k/yr tops and that eats all of your cash flow even with the reduction in operating costs. So net net, you are flat monthly. What if your vacancy rates increase, now you are paying out of pocket. Ouch! You are however paying down a loan and possible appreciation. Banking on appreciation alone is extremely risky – 50% in 5 years? I don’t think so. Over a longer term horizon, it is possible.

To summarize, $350k investment to be potentially negative cash flow monthly is not desirable. What is better? I have no clue in this environment. All assets are high – risk reward is not there IMO. GL investors.

What am I missing? Forgive me if I’m wrong but, your NOI after 5 years using that income and expense % should be $152,460. Where is the $166,957 coming from? Also, using the terms you gave for the debt service (the chart is showing 6% at 25 years) you get $59,535 annual debt service. When I plug in those numbers I am getting $82,196 for the annual debt service.

Down payment of 25% of 1,417,500 results in having to finance $1,0631,000. Under debt service it’s listed as 30% down.. but under down payment it’s listed as 25% down (not sure why the discrepancy??).

Financing $1,0631,000 at 6% for 25 years.. leaves a monthly payment of $6,849, or over the course of a year, $82,196. With initial NOI at $113,400 – Debt Service of $82,196 = $31,204 yearly cash flow, or approximately $2,600 a month cash flow, or $123 per unit of cash flow.

I was just looking at a somewhat similar deal here in Massachusetts.. actually wasn’t as good as the numbers in this example, and while in the long term increasing rents and decreasing expense has some promise..

It’s hard for me to justify investing $354,000 for $2,600 a month cash flow.. that’s about an 8% cash on cash return.. while having to deal with 21 tenants.. I invest in small multis 2-4 units.. and generally find better returns, with far fewer tenants, and headaches.. but keep thinking I should be thinking bigger and scale up.. but the numbers never quite make sense to me on the big properties.. at least here in expensive Massachusetts.

Zach,
Some Examples of what you might do to reduce expenses:
— Implement the RUBS system to pass water/electrical expenses to tenant, or sub-meter (more expensive)
— Lower payroll overhead. If the previous property manager employed a full-time maintenance person and leasing agent for managing a 50-unit, you’ve got a problem. A good property manager should be able to do without that pay roll
— Appeal real estate tax assessment: I’ve done that successfully and saved $1500 per year.
— Install water-savers throughout to really reduce water if you’re paying for it.
— Shop your insurance: I cut my insurance about 30% over the previous owner by doing just that.
Just some examples …
Thanks!

Great article showcasing the merits of commercial property! I currently own a few small multi families but would like to move up the ranks a bit into the commercial space. Do you have any books or any other good reads you’d suggest prior to jumping into something of this caliber?

Hi everyone. I appreciate all of your comments and participation. In paricular Cody and John who took the time to check my math and alas, discovered mistakes and inconsistencies that I’d like to correct. I now understand how this happened (by copying values from my deal analyzer into this simpler table) but it was sloppiness – plain and simply – and I’m sorry about that. Let me try to correct my mistake and hopefully I’ll get it right this time.

After fixing my math, the bottom-line profit number changed from $1.062M to $963M — so not quite $1M as advertised in the title but close. The good news is that my main point still stands: commercial real estate CAN create substantial wealth if you can buy right and create value.

However, the math MUST be correct in the process. So let’s fix that.

Cody and John: both the NOI and debt service were indeed incorrect.

More importantly the main flaw in my case study was the disconnect between my more sophisticated deal analyzer and my simplistic table. In my financial model I assume the rents and expenses increase by 3% each year. In our case study, I postulated that it would take us a year to get the average rents up by $100 (from $1,000 to $1,100). After that, we assume rents (and expenses) both increase by 3%.

This changes both the income and expense numbers. This means that in Year 5 we have:

Two other metrics I like to look at when evaluating property are as follows:

Cash on Cash Return – In your example of Down payment around 354K, and a cash flow of 84K per annum your cash on cash return is around 24%. for a fully stabilized property. Thats awesome performance. Now you might be the best day trader in the world, but a normal investor would more likely make between 5-10% return on a stock.

Percent Return on Equity – In this example, 84K return on a total equity by year 5 of around 900K (2.1 million sell price minus 1.4 million purchase Price less down payment) gives you a 9.3% return on investment. Your approaching returns similar to the stock market at this point so it might be a good Idea to cash out and purchase something that will yield you better returns on your total net worth. Less than 10% return on equity I view as a sell signal.

Michael, I like the simplicity of your initial Scenario. Your point stands, one can creat wealth through Commercial Real Estate. 2 key points, know your market and your product. The investment can be viewed as passive (once you dial it in) but owners spend a lot of time educating themselves before, during, and after ownership.

I highly recommend that people buy and plan to hold. This will keep your investment a little less risky since you can choose to hold on year 5 if the market has taken a dip. Wait till the cap rate is a 8 cap or less and sell. We can’t predict the future, but we know that markets always go up and down. Plan for both.

very, very possible. having all the pieces to this would seem daunting. BUT very doable. I am sure for the right team and qualified people this is idea. I will turn a deal like this some day. You do make a point in selling it in 5 years. What if you held it? that is a very high net cash flow. That turns better than alot of people can say in their current career.

I see this great potential in multifamily real estate and decided to give it a try. Turns out, theory and reality are two distinct worlds. What looks good on paper is a total mess in the real world.
Each market might be different, for sure, but here in the Seattle area, unless you have several million and settle for 4% CAP rate, it’s a waste of time.
Looking at some of the more attractive properties with more units and higher cap rates, it turns out that every single seller is lying badly about expenses – they are using 2012 expenses to justify the value, so when you run the actual numbers, the building would be worth barely half of what they are asking. However, they will not budge on the price because they are getting a lot of interest and/or similar building sold for that much.
Financing is another nightmare. 25% down is absolute minimum, 30% is preferred. But that’s just the beginning, lenders require that you have net worth of at least the loan amount, so 1 million at least, and that you have experience with multi family and so on.
So in my experience, smaller multifamily are not really worth the trouble (unless they are in very good neighborhoods), but you can’t start with anything bigger. That is what nobody tells you.
Interestingly enough though, rather than dealing with small mutifamily property with crummy tenants, it’s far better to own just one or two single family homes that will cash flow the same, appreciate much more and they are very simple to manage. Perhaps after you are worth that 1 million, jump into some bigger deal that’s worth the trouble. My 2 cents.

Welcome to reality. I have been playing this game, and what you have stated is absolutely correct. Also, I notice that Michael didn’t include vacancy in his calculations. A 5% vacancy would shave $16k off his cashflow. :0)

Michael, great article! Are you bringing in an investor for the $354,375 down payment? If so, what terms would you give them? It seems to me that most investors don’t have that kind of money lying around to do deals so they would likely need an investor.

Hi Scott … yes, I *would* bring in investors. The example above is without investors. Even though your share of the profits would be less, the principal still holds. Depending on the deal, I would give investors between 70% – 90% equity in the deal, with you (the syndicator) retaining the rest …

Michael thanks again for the great article. It is amazing how increasing rents and reducing expenses (even slightly) can magnify your returns.
You mentioned than investor(s) would require 70-90% of the equity. Let’s use a middle number of 80%. Does that mean the investor receives 80% of the $963,544 or $770,835.20?
If so, wouldn’t you be better of just paying the investor(s) a fixed return of 10-15% each year from cash flow, keeping the remainder as your fee and then keeping the equity when you sell or refi and repay the investor(s)?
Maybe I am missing something. Will investors accept 10-15%?

Awesome article broken down to be easily understood! I loved it and the fact that you broke the numbers down into such detail really helped me as I’ve never really analyzed a multi family before. Thanks a lot Michael! Will probably have to watch a few more times to really digest it all 😀

Michael, thank you. I’m at a turning point where I have a partner who wants to invest with me, so my goals getting bigger and timeline to reach them shorter – I’ve been wondering if we should pursue flips or small commercial, as that’s where we would be able to compete best in our market. I will definitely be keeping this article in mind as we make our decisions!

Great article Michael! I do have one question though, why do you sell after five years? Is it just because you have already made a great profit and it is time to pull your money out and repeat the process? I always saw apartment investing as a long term type of deal.